PRESENT STAGES OF ECONOMIC REFORMS ANDPRIVATIZATION PROGRAMS IN EASTERN EUROPE:

THE CASES OF EAST GERMANY, CZECHOSLOVAKIA,POLAND AND HUNGARY

Lucjan T. Orlowski

Working Paper #156 - April 1991

Lucjan T. Orlowski is currently an American Council on Education and Faculty Fellow at theUniversity of Notre Dame. His academic career began at the Academy of Economics in Katowice,Poland, where he received a doctorate in international economics. His dissertation focused oncomparative systems of trade protectionism. In 1981 he was coauthor of a Solidarity sponsoreddraft on economic reforms completed at the Academy of Economics at Poznan. From 1981 to1983 he was a Visiting Fulbright Professor at New York University Graduate School of BusinessAdministration, where he taught and conducted research in international economics, finance, andbanking. In 1983 he became a faculty member at Sacred Heart University in Fairfield, Connecticut,where he held the positions of Chairperson of the Department of Financial Studies and, morerecently, of Acting Provost and Academic Vice President. His publications concentrate on issuesof informational economics, decentralization and marketization of economic systems,macroeconomic stabilization, and trade policy.

ABSTRACT

East European economies are in the process of experiencing an unprecedented transition from acentral planning to a market system, parallel to the democratization of the political sphere. Themain purpose of this paper is to show a sequencing of the economic deregulation andexpectations at each stage of economic transformation. The author presents a critique of centralplanning and advocates a free market as a desirable direction for reform programs. Selectedcomponents of these programs are critically examined. Among them, far reaching andunrestricted privatization, discretionary monetary policy, full convertibility of domestic currenciesand large-scale deregulation of businesses are favored. The author emphasizes the dangers forsuccessful reform of excessive taxation, protectionism, and exaggerated regulatory involvementof governments. He advocates a comprehensive, gradually sequenced approach to reformprograms somewhat different from the “shock therapy” proposed by several academiceconomists and government policymakers. The suggested transition to market structures issubdivided into three stages: 1. the period of decentralization of major pricing categories; 2.decomposition of monopolies and activation of competitive markets; 3. accelerated economicgrowth and capital accumulation. Anticipated patterns of inflation, exchange rates, interest rates,and national income are derived for each of these periods. The final section examines currentproblems of integrating the East German provinces and implementing reform programs inCzechoslovakia, Poland, and Hungary. Concluding remarks focus on aspects of East Europeanrestructuring that may affect multinational firms’ strategic plans for their involvement in this region.

RESUMEN

Las economías de Europa Oriental están en el proceso de experimentar una transición sinprecedentes de un sistema central planificado a un sistema de mercado, paralelo a unademocratización de la esfera política. El propósito principal del trabajo presentado es el demostrar una secuencia de deregulación económica y de expectaciones a cada etapa de latransformación económica. El autor presenta una crítica al sistema central planificado y aboga porel sistema de mercado libre como una dirección deseada de los programas de reforma.Componentes selectos de estos programas son examinados críticamente. Entre éstos sonfavorecidas una privatización de gran alcance y sin restricciones, una política monetariadiscrecional, la convertibilidad total de las monedas nacionales y una deregulación a gran escalade empresas. Son recalcados los peligros de impuestos excesivos, del proteccionismo y de laspolíticas regulatorias exageradas por parte de los gobiernos para asegurar el éxito de las reformas.El autor persigue un análisis comprensivo, de secuencia gradual de los programas de reforma,algo diferente a las “terapias de choque” propuestas por varios economistas académicos ypolíticos gubernamentales. La transición a estructuras de mercado sugerida se subdivide en tresetapas: 1. el período de decentralización de las categorías de precios principales, 2.decomposición de monopolios y activación de mercados competitivos, 3. una acumulación decrecimiento económico acelerado y de capital. Patrones de inflación anticipados, tasas decambio, tasas de interés y de ingreso nacional son derivadas para cada uno de estos períodos.La sección final examina los problemas actuales para integrar las provincias de Alemania Oriental ylos programas de reforms en Checoslovaquia, Polonia y Hungría. Las observaciones finalesenfocan aspectos sobre la reestructuración de Europa Oriental que pudiesen afectar los planesestratégicos de empresas multinaciones relacionados a su involucramiento en esta región.

I. General Goals of Economics Transformation

Since the mechanism of central planning has essentially ruined East

European economies, the ultimate goals for their reform are constructed as an

antithesis to the command system. There is neither a comprehensive theory

nor sufficient practical experience of a full transition from centrally planned

to a decentralized market economy. Therefore, nations like Hungary, Poland,

Czechoslovakia, and East Germany are in the process of undertaking a truly

pioneering experience.

Formulation of ultimate goals for their economic reconstruction is a

fairly easy task, although a full understanding of these goals is more

complicated since these societies are not accustomed to the functioning of a

market-based system. The discussion presented here on these common goals

attempts to emphasize their interpretation and economic impact.

Superiority of a market system as a goal for East European economic

reforms arises by antithesis to the major reasons for the failure of the

command economy mechanism. At least three broad causes of the collapse of

socialist central planning can be noted here. Firstly, there was a separation

between an exclusive decisionmaker (the government) and decision executors

(firms and society) which led to a passiveness in social economic initiatives.

Reformers wish to rebuild the entrepreneurship and innovation of people and

firms under conditions of market competitiveness. Secondly, both the

quantitative and the value-based central planning led to a substantial

technological retrogression of state-owned, monopolistic firms. They were

only interested in producing the assigned quantity or value of simplified

products, not having the technological incentives to win a market share that

normally occur under competitive structures. Thirdly, the same planning

mechanism caused a lack of cost saving efforts, since companies were

accountable only for the final output at whatever costs they incurred. It was

sometimes in their interest to maximize costs in order to drain more easily

obtained state subsidies. This situation led inevitably to a high land and capital

intensity of production and consequently to overstated material costs and low

value added. It is believed that a market system will correct these deficiencies.

The targeted system is consistent with general messages of free market

capitalism, where economic decisions depend upon supply and demand

conditions and equilibrium prices. Deregulated prices of goods and services,

interest rates, exchange rates, and wage rates are expected to fulfill an

informational function, which they could not satisfy under the centralized

system. As they are able to do so, the society’s knowledge and productivity will

be better utilized. This assumption reinforces a statement by F. A. von Hayek

that “no centralized system is capable of gathering and processing the

requisite information coordinating activities as efficiently as a decentralized

free market economy.”1 Previously, the economic information system was

based on massive amounts of data exchanged through bureaucratic channels

between the government and economic agents, where fixed prices and

production quotas reflected the authority’s preferences rather than the

society’s. The new system is expected to release forces of the “invisible hand”

where the price system transmits buyers’ preferences, production, and

allocation messages among different economic agents. Consequently, the

reform programs are to be built on deregulated prices, market interest rates,

and flexible exchange rates, not distorted by any type of central interference.

The second commonly acceptable goal is competition and freedom of

choice. For this purpose demonopolization of existing structures and a shift of

responsibility for economic decisions from governments to consumers and

businesses are required. It is no longer society’s role to await and then to

execute economic decisions that were often based on limited and distorted

information. A new type of social creativity and initiative is expected from

workers, consumers, and business leaders, who are now empowered, but not

quite ready, to make such decisions. Today, the problem is especially evident

in the case of East Germany, where Western firms are signalizing difficulties

with finding a proper degree of entrepreneurial ability in a society still

hibernating as a result of central planning. Under new conditions of

competition, societies are motivated to generate profit-seeking businesses. At

the same time, they will have to accept many business failures. Many of

today’s unprofitable companies still function under “hothouse” conditions

consistent with what Janos Kornai calls a “soft budget constraint”—a weak

financial discipline of state-owned firms always kept afloat by heavy

government subsidies.2

1 See Hayek, 1948.2 For an extended discussion see Kornai, 1990, pp. 57-79.

The third general goal for Eastern Europe is privatization, understood in

the sense of contemporary capitalism. No longer will the means of production

belong to the state, thus no longer can they be misused, neglected, or

inefficiently employed. Moreover, the main purpose of public stock emission

of today’s large state companies may be to create an opportunity to access new

sources of external capital for their future expansion. The capital stock

cannot just be given away to employees, who have a limited excess liquidity

anyway, but should be open to anybody who is willing to invest funds in the

company. On many occasions East European authorities have expressed fears

about excessive selling of national companies to Western, particularly West

German, investors or speculators. Their position is understandable from a

perspective of a prewar capitalism, but today these reservations ought to be

largely discounted, since most of the contemporary corporations are managed

effectively by top executives facing numerous dispersed shareholders rather

than a few exclusive owners. It is imperative, that reforms of property rights

and financial and accounting systems are instituted concurrently with

privatization.

The main feature of structural reforms is a departure from central

planning and directing economic activity on the microeconomic level to a

macroeconomic stabilization policy. Governments are expected to use fiscal

and monetary policy tools identical to those presently available to industrial

market economies. Direct price controls and allocative priorities to heavy

industries will very likely be ended. Agriculture, consumer goods, housing,

and service sectors will gradually regain preferences that were suppressed by

socialist central planning.

A strong managerial role played by governments is expected in the

transition period to the macro-oriented policy. It is a paradoxical

phenomenon, since the ultimate goal of the economic reform is a market-

based system with limited interference from policymakers. Economic leaders

will face a need to end the proactive regulation of business operations,

granting them more freedom. Central management of fiscal and monetary

policies is essentially unknown to government leaders in Eastern Europe, so

long accustomed to planning directives.

Governments are expected to apply an expansionary fiscal policy in the

transitional period. Progressive tax rate based income policy is designed to

repress inflation. Strong government funding for economic restructuring is

desirable as well. On the other hand, subsidies and tax breaks supporting

noncompetitive businesses will be phased out.

Plans for currency convertibility and deregulation of commodity and

capital markets will confront weak, comparatively disadvantaged Eastern

economies with leading Western manufacturers and financial institutions.

Consequently, fiscal policy will be aimed at strengthening desirable firms that

can be expected to gain a competitive position in world markets. As a result of

fiscal expansion budget deficits will arise. The easiest, yet the most dangerous,

way to offset these is heavy taxation. It is essential that governments reject

this in order not to spoil business initiatives, savings rates, and the entire

program of restructuring. A prefered way of financing budget deficits is a

creation of public debt, so far not applied by these economies. If excessive

debt to GNP ratios occur in the remote future, accommodative, proinflationary

monetary policy will likely take place to reduce them. It is imperative that the

postsocialist policymakers observe the nature, dimensions, and dangers of

contemporary fiscal policies in developed market economies to ensure their

skillful management. A fiscal burden, unavoidable in the transitonal period,

can be eased by a further expansion of Western credits supporting programs

of economic restructuring.

A crucial part of the macroeconomic refocusing is the construction of

commercial and investment banking systems, central banking, and an active

monetary policy. Experienced personnel in this area are scarce and training

needs are substantial. No longer will these countries have a monobank

serving exclusively as a channel of collection and distribution of funds. A

multiple and competitive banking system will have to be instituted in order to

generate an active monetary policy and money markets with equilibrium

interest rates serving as the most important measure of investment efficiency,

forcing companies and individuals to the most profitable portfolio structures.

The rates will also reflect information about inflation expectations and

liquidity shortages or surpluses and will ultimately provide a ground for

currency stabilization. Until such markets are effectively in place, all East

European currencies will substantially depreciate. It is essential for economic

reforms today that priority be given to a construction of a solid central

banking system. The groundwork for such a system was presented recently at

a conference on East European central banking, which took place in a

“noneconomic wilderness” of Wyoming, with creative presentations offered

by New York Federal Reserve Bank President G. Corrigan and several

economists from the IMF, World Bank, and academic institutions.3 Successful

establishing of profitable business firms was stated as a necessary condition

for an efficient financial system. It is imperative that the newly emerging

financial institutions in Eastern Europe are viewed as safe and convenient

outlets for public deposits, where a large fraction of savings will be highly

liquid and used to make payments and generate credits. Inexperienced

bankers in that region need a fair amount of guidance through sizeable

regulation and oversight, primarily in the area of management of the

desirable level of reserves and prudent credit allocations. The correctly

working system will direct credit to the most efficient, most competitive, and

most profitable recipients who will become the most capable of producing the

stream of goods and services that will permit the economy to grow. East

European bankers face the task of assessing the size and the composition of

banks’ capital account as a source of permanent funding and as a cushion for

eventually occurring losses. The capital base is expected to serve a function of

creating a constituent group of individuals and institutions who will have a

direct interest in the profitability of the banking system. For this reason

private ownership of financial institutions should be the most desirable

solution. It is not easy to achieve these banking system foundations. It will

take time to educate managers of financial institutions, to create public

confidence in the financial system much damaged today under galloping

inflation, especially in Poland, and also to generate sufficient domestic capital

accumulation. Conditions of low inflation and positive real interest rates are

absolutely essential for this purpose. In addition, an excessive outflow of

domestic capital to satisfy external debt payments must be prevented through

rescheduling and through foreign actions foregoing large portions of

obligations. This will help the domestic financial system to accumulate capital.

The desirable time for a sound financial system reform is perhaps the most

important obstacle to the Polish concept of a “leap to the market economy”

advanced by Deputy Prime Minister Leszek Balcerowicz and by Harvard

economist J. Sachs.4

3 See Corrigan, 1990.4 An extensive description is provided by Lipton and Sachs, 1990, and by Sachs and Lipton,1990.

Almost all East European markets, commodity, capital, labor etc., are too

weak to face a competitive confrontation with the developed Western

economies. So far they have been isolated by centrally planned systems

serving a function of extreme protection. Prevention of excessive injuries

can be expected to emerge as an argument for a sizeable protectionism based

on nontariff barriers, sophisticated subsidies, and capital flight controls

contrary to GATT arrangements. It is questionable whether Poland,

Czechoslovakia, and to a lesser extent Hungary will be able to avoid a similar

phenomenon to the East German experience, where the economic merger with

the West completely redirected domestic aggregate demand on Western goods,

literally crushing the inadequate local economy. The expected protectionist

tendencies may delay the much desired collusion of Eastern Europe with the

European Community and may impede its smooth cooperation with other

members of GATT.

Discussion of the role of a central bank in the new economic system

should not bypass the issue of how to manage monetary policy. It seems more

appropriate that a central bank, as a single monetary authority, will initially

pursue a discretionary policy, rather than rigid rules of money supply

growth. This advice is contrary to the calls of monetarists in the process of

construction of the East European system.5 The rationale for a discretionary

approach is that the initial formation of money markets and the commercial

banking system, combined with a decomposition of monopolies in the

production sector of the economy, will very likely be accompanied by severe

monetary shocks. For instance, price decentralization usually happening

before demonopolization of industrial structures may cause excessive inflation

resulting in a sudden increase in the demand for money. A central bank will

have to react with a strong liquidity injection to the monetary system. In

addition, we may expect some mistakes from inexperienced commercial

bankers in the transitional period in management of a desirable level of

bank’s reserves. Again, offsetting liquidity reactions will have to take place.

Furthermore, reaction lags between different monetary aggregates may be

more severe under newly constructed economic systems than those known to

monetary systems in industrial market economies. All these conditions will

5 Such a call was presented, for instance, at the Conference on East European Central Bankingin Wyoming in August 1990 by Prof. Alan Meltzer.

require skillful discretionary liquidity reactions by new monetary authorities

in Eastern Europe.

There will also be a profound role to be played by investment banks in

the process of privatization and securitization of firms. This subject is much

neglected in the present discussion on economic reforms. There can be no

rational program of stock emission and future trading without involvement of

skillful investment bankers. In the present program of privatization in

Poland it is the government that assumes responsibility for these issues in the

absence of investment banks. Establishing a solid foundation for an

investment banking system should be a prerequisite for the privatization

program.

A separate, much debated issue in the description of the transitional

period from a planned to a market economy is a problem of a proper speed and

sequencing of reforms.6 The overall discussion seems to favor “shock

therapy” of the Polish type. It claims that the advantages of fast adjustments

outweigh predictable transitional costs, or disadvantages. The fast speed is

believed to diminish transitional costs and to make the reform program more

credible and comprehensive. Condensed solutions will make the issue of

proper sequencing less relevant. Many reservations to these arguments can

be raised. First of all, rapid pace of reforms does not mean that they are

automatically comprehensive. On the contrary, the leap to free market

structures can be faced by unprepared entrepreneurial ability and by

unadjusted financial system, “patched” by heavy government interference.

Such loopholes may undermine the comprehensive character of the reform

program.

However, favoring fast speed is also based on some legitimate

arguments. Past attempts at partial reforms, particularly in Hungary and

Poland, sometimes produced perverse and unintended results. It seems,

however, that improper sequencing can be blamed for their incomplete

success, since these reforms have been usually limited to decentralization of

prices without a true decomposition of monopolies and formation of a

competitive financial sector. For instance, the Polish wholesale price reform

of 1971 was accompanied by the formation of even more monopolized

structures called “Large Economic Organizations,” and in response to the

6 See both papers of T.A. Wolf, 1990, for an extensive analysis.

danger of emerging price increases the government instituted a policy of

suppressed inflation fixing almost all retail prices at a low “ceiling” level and

consequently yielding painful shortages. The most convincing political

argument for a faster speed is that rapid changes will prevent eventual

obstruction of the reform program by bureaucrats of the former system

fearful of losing jobs and influences. Fast changes will also take advantage of

the momentum of an enthusiastic public support for a transition to democracy.

Some social concerns about speedy adjustments can be also added. The

process of familiarization with the market system by workers, managers of

new, independent firms, and the financial sector will have to be accompanied

by training programs that cannot produce results overnight. Some optimism

about this process may arise from experiences of Eastern immigrants to the

West who have frequently become entrepreneurial and competitive in a

relatively short period of time, being previously equipped with a high level of

general education. Yet again, their success stories did not happen overnight.

More importantly, a fast speed of marketization requires a very detailed

government interference with business, since inexperienced institutions need

great deal of guidance and regulation. Such inherently inefficient, sizeable

intervention is inconsistent with the ultimate goal of the reforms, which is a

deregulated free market system. It is hard to predict whether governments

accustomed to and comfortable with interventionist economic policy will be

ready to give up excessive regulation as quickly as possible once competitive

market structures are in place.

Since there is such limited theoretical guidance for the reform

programs in Eastern Europe, an outline of their sequencing is a speculative

task. For this reason, forecasts of major economic indicators can only be

intuitive, based on available macroeconomic models. Data extrapolation from

past trends would be erroneous, owing to a complete change in economic

structures.

It can be also noted that there is a change in the importance of

production factors for East European economic systems, which will have an

impact on the determination of values of goods and services. Socialist

economies led by the Marxist labor theory of value gave a strong priority to

the quantity of labor employed, neglecting capital formation and land

utilization, and causing careless and inefficient exploitation of natural

resources resulting in high energy intensity and pollution and undermining

the importance of developing entrepreneurial ability. The new system will

have to be designed to ensure efficient utilization of all factors of production.

Needless to say, it must be consistent with the capitalist theory of value and

profit maximization as a leading criterion of economic activity.

II. Stages of Transition and Expected Economic Effects

Based on currently available reform programs, the transition from

central planning to a market based system can be subdivided into three stages:

A. The period of decentralization of major pricing categories,such as prices of goods and services, interest rates, exchangerates, and wages.

B. The period of decomposition of monopolies, activation ofcompetitive market structures, privatization, and currencyconvertibility.

C. The period of accelerated economic growth and capitalaccumulation under new market conditions.

This classification has been intuitively constructed, based on

corresponding relationships among major economic indicators illustrating a

stabilization policy, such as inflation, unemployment, interest rates, flexible

exchange rate, and real GNP trends. The distinctions among periods A, B, and C

are based on outlines of reforms proposed in Hungary and Poland. The

assumption that stabilization policy is not countercyclical is made here, in

order to investigate changes in economic variables induced solely by market

interactions.

The trend of anticipated inflation can be drafted as follows (Figure 1):

°P A B C

______________________________________ Time

Figure 1

Initially in stage A, deregulation of prices under monopoly conditions

should result in adjustments to world market prices in a monopoly price

setting. Inflationary effect will therefore be very significant. Poland has

already experienced this wave of inflation reaching 700% in 1989 followed by

the 78% monthly rate in January 1990 gradually slowing to 3% monthly rate in

June 1990. Czechoslovakia deregulated prices of agricultural products, which

are presently sharply accelerating. East Germany’s inflation effect was

avoided by a drastic increase in the purchasing power of the Eastern Mark as a

result of the July 1, 1990 one-to-one currency conversion to Deutschmarks. In

the second stage, decomposition of monopolies and activation of competitive

markets should substantially diminish inflationary pressures. There will be

also a much lower purchasing power of consumer incomes left after stage A,

therefore real consumer spending will be also lower and demand induced

inflation will fade away. Currency convertibility may occur very late in this

stage, and if not restricted it may cause a stronger demand for foreign

currency selling out domestic money and absorbing some inflationary

impulses. The privatization program will also lower the inflation overhang,

redirecting any available excess liquidity to investment in equity shares.

Promptly introduced securitization of capital assets, fully and openly available

to domestic investors, may substantially reduce inflation. The remote stage C

should be able to bring about capital accumulation generating the economic

growth. Nevertheless, labor costs are and will

remain at least four times lower in the region compared to the European

Community and investment opportunities in infrastructure, services, modern

technologies, etc., will be enormous. The new growing economy will likely

increase aggregate demand and will add to inflationary pressures in a long,

rather undetermined time. The described “normal” trend of inflation assumes

that monetary policy will not counteract with it and a fiscal deficit will not be

financed by creation of new money.

Corresponding changes in real interest rates r will be eminent in stage

B, when an active money market emerges (Figure 2). This stage will create a

stronger demand for credit for the purpose of establishing new businesses. A

skillful monetary policy response will be required. A consideration for

central banks will be to inject enough liquidity to meet the increasing demand

for money. At the same time, they will have to keep interest rates somewhat

stronger to induce society’s savings in order to create a potential for the

intended expansion in period C.

r A B C

_________________

_________________________________________________ Time

Figure 2

The effective exchange rate e will very likely experience depreciation

in phase B, assuming that it will be flexible, or market determined, with some

stability reached in stage C (Figure 3). Appreciation of domestic currencies

seems to be extremely unlikely throughout the entire transitory period.

eA B C

_______________

_____________

______________________________________ Time

Figure 3

It can be noted that at the end of phase B domestic capital will be very

inexpensive to foreigners. It is also necessary that debtor nations, such as

Poland or Hungary, will generate trade surpluses to ensure a relative stability

of their exchange rates. Consequently, the program of full currency

convertibility will become more feasible. Figures 2 and 3 also imply that the

currency rate sensitivity to changes in interest rates will be very small,

because it is hard to anticipate that East European economies will become

attractive to allocations of international financial capital investment in the

transitory period. Adversely, stimuli for foreign direct investment and

proexport activities may very likely occur. In addition, any possible import

incentives will be directed toward high-tech goods, transferring modern

technologies to the depressed economies and also toward capital and

intermediate materials alleviating shortages and bottlenecks in the transition

period. There will be almost no effect of import competition stimulating

domestic producers of consumer goods in the near future, since the quality

and technology gaps are too drastic. For this reason, the total value of imports

may outweigh the growth of their volume if domestic consumers tend to buy

mainly foreign goods as a result of full currency convertibility. Demand for

imports will become highly inelastic and the trade deficit may expand. These

effects may occur under the absence of protectionism.

A combination of the conditions discussed provides a ground for the

anticipated trend in real gross national product Y (Figure 4) and the

corresponding rate of unemployment (Figure 5).

YA B C

100% __________________________________

______________________________________ Time

Figure 4

A B C

NaturalRate ∗ ___________________________________

______________________________________ Time

Figure 5

Stage A has an unavoidable recessionary impact with unemployment

rates rising well above the natural level for these economies. This shock may

be quite significant, considering for instance the jump in the unemployment

rate in East Germany at the beginning of September 1990. New business

opportunities enforced by training of workers and managers primarily in the

field of organizing small businesses should lower the unemployment rate to a

stable level in the long run. Since monetary policy will still be inactive in

phase A and only gradually developed in B, no evident tradeoff between

unemployment and inflation is expected to occur. Among the factors

contributing to an accelerated economic prosperity in stage C are higher

domestic investment and growing incomes, followed by a stronger real value

of consumer spending. Investment attractiveness will be ensured by

preferential labor costs in the region and in some cases by abundant natural

resources.

In conclusion, it can be argued that no evident incentives for foreign

direct investment and/or export by economies of industrial nations can be

found in stage A. Only periods B and C will generate such stimuli. It is

therefore advisable from a purely economic standpoint for U.S.-based and

other multinationals to delay their involvement plans in Eastern Europe (with

the exception of East Germany) until reform programs are consistent with the

described nature of these two stages.

III. Individual Cases: East Germany, Czechoslovakia, Poland, and

Hungary

There is no standardized program of economic reform in Eastern

Europe. Long-term consequent realization of principles of marketization

applied by Hungary, a more cautious approach to transformation in

Czechoslovakia, a “leap to a free market” in Poland, and the East German

inclusion in the all-German economic system are entirely different ways to

accomplish similar goals of a market-based economy discussed before. These

four nations will be more specifically analyzed below. Interesting proposals

advanced recently in the remaining countries of the former Soviet Bloc, such

as Bulgaria, Romania, and the Soviet Union itself, will not be covered since the

conditions of political reforms and stability needed as a threshold for economic

reforms have not been accomplished there yet.

East German Territory

On July 1,1990 the former German Democratic Republic merged its

economic and monetary system with West Germany. On October 3, 1990 both

countries became politically unified, ruled by the interim government until

the December 2, 1990 all-German election. The East German territory is still a

local district which has inherited tremendous economic problems left behind

by the Soviet-backed rulers.

Throughout the year of 1990 the Eastern noncommunist government

had to prepare thirty major legislative acts reforming everything from

property rights, trade laws, banking, privatization, and the accounting system

to reorganization of state companies. The most centralized and rigorous

economy of Central Europe was forced into a free competition with one of the

most effective and advanced economic systems and the largest exporter of

goods and services in the world. Even in June 1990, right before the monetary

unification, almost nobody realized the degree of the economic retrogression

of the East German system, previously viewed as the most advanced in the

Soviet Bloc. Government economists predicted at that time only about 30%

unavoidable business closings owing to obsolete capital, trusting that the

remaining 70% could be subject to modernization. However, Eastern

consumers reacted with unwillingness buy locally produced goods after the

currency swap, because of their low marginal utility. Current predictions

claim that approximately 70 to 80% of Eastern capital is completely useless.

The productivity gap is equally shocking. Although Eastern wage rates

are still about four times lower than Western, the number of workers for the

same comparable market value of output is about four to five times higher.

Managerial skills are significantly depressed. Thus it is no wonder that the

current unemployment rate has jumped to 27%. Massive training of the

workforce is the most needed solution to this problem. Easterners need to

acquire entrepreneurial skills for future establishment of small businesses.

Considering the much depressed service economy, the risks in opening small

businesses are enormous. Today the region has many scattered gas stations,

shops, banks, restaurants, etc. The need for training is supported by an

example from the Hannover Chamber of Commerce, which in fall 1989 offered

a training program for 200 Eastern managers. Six thousand people signed up

for it.

The key objective of reforming the East German territory is to narrow

the gap in living standards with the West. Prompt action on this task will

eventually prevent a continuous outpour of Easterners threatened by job

insecurity and seeking opportunities in the booming West. To illustrate this

gap we may compare the percentage of households with

automobiles: 52 in the East, 97 in the Westcolor TVs: 52 in the East, 94 in the Westtelephones: only 7 in the East, 98 in the West.7

The communications sector was very much depressed by the Communist

rulers for the purpose of better information control in the society. To German

policymakers reforming the East means unifying with the West. At this time

the macroeconomic effects of the unification are more predictable.

The presently soaring unemployment, estimated to reach 27% in April

1991, is expected to rise somewhat higher next year before it will show any

declining tendency. Long- term labor market perspectives are not gloomy at

all for the following reasons:

1. Eastern workers are much less compensated, while theirgeneral level of education is very high.

2. The salary gap will eventually induce job-creating foreigndirect investment despite several failures of prematureventures by West German firms presently recorded.

3. Potential employment needs in the service sector are verystrong.

The initial threat of unemployment will also substantially improve

workers’ productivity much neglected by the 100% job security guaranteed by

the socialist government.

Inflation expectations stemming from the monetary unification are

much overstated. The overall implicit price deflator for the combined

economy should remain relatively stable, with some internal realignments

among values of individual types of goods. At the one-to-one swap of German

currencies, overvalued and obsolete Eastern durables are already downward

adjusted while food prices are somewhat increasing. Excess inventories of

Eastern goods are emerging, which in combination with the strong German

propensity to save will not result in any excess money supply that could yield

inflationary consequences. The July 1,1990 currency unification enforced

7 Source: IMF: World Economic Outlook, May 1990, p. 90.

conditions contrary to Gresham’s Law—the economic phenomenon of an

inferior currency replacing a wider use of the stronger one. It is the mighty

Deutschmark that has replaced the weaker Eastern Mark in circulation.

The balance of payments effect of the economic unification should not

pose a meaningful disturbance. The inherited external debt of East Germany,

totalling $17.5 billion at the end of 1989, is only about 2% of the West German

nominal GNP. It should be emphasized, that the largest commercial bank

lender to East Germany was Japan (with $3.9 billion), not West Germany (with

$2.9 billion). The free market value of $100 outstanding East German debt was

recorded at a high level of $97 in April 1990 (comparing to only $14.50 for

Poland’s debt). This indebtedness is not significant and can be easily absorbed

by the West German monetary system.

The long-term optimistic outlook should not overshadow serious

structural problems of the East that the united economy will have to face.

Perhaps the most severe impediment is an exceptionally high degree of capital

concentration, even for an average scale of Eastern Europe. In the eighties

the industrial sector was further reorganized into only 132 conglomerates.

The second painful problem is the strong economic reliance of the Eastern

economy on lignite coal for energy and the chemical industry. In

combination with the high overall energy intensity, this has created

unbearable pollution. East Germany has currently the highest per capita

sulphur dioxide emission in the world. Finally, the areas of specialization in

the manufacturing sector have much departed from desirable allocations from

the standpoint of comparative advantages. Much of the investment stream

went over the years into noncompetitive technology intensive projects,

neglecting capital stock formation in other areas especially in consumer

product industries.

The leading force in the economic restructuring of the Eastern land is

expected to be West German commercial banks, on top of special funds

designated for this purpose by chancellor Helmut Kohl’s government and by

the Bundesbank. A fierce territorial battle for influences in the East has just

began among the three banking giants: Deutsche Bank, Dresdner Bank, and

Commerzbank. All of them have formal plans to establish numerous branches

in the East as soon as possible. Dresdner is considering moving its

headquarters to Dresden, where it was founded in 1872, and the two others are

discussing relocations to Berlin. Deutsche Bank wants to establish a network

of about 300 branches; part of them will be acquired from Eastern Kreditbank

(former Staatsbank) to set up as a joint venture universal bank.

The process of economic restructuring of the East involved in 1990 a

substantial reduction (approximately 20%) of the manufacturing output,

similar to conditions described here as stage A. This trend will be also

continued next year, although it is premature to analyze how effectively the

banks, Western corporations, all-German government, educational centers,

and others will be able to act on a construction of the entirely new economy

much oriented to a service sector and to competitive areas of industry.

Czechoslovakia

The country is perceived as the technically most advanced East

European economy, having the lowest degree of external debt of only $5.4

billion. The indebtedness, in combination with $2.4 billion reserves of gold

and convertible currencies at the end of 1989, is not a significant impediment

to economic reforms. On the negative side, the industrial output is highly

energy intensive, which causes pollution only marginally better than in East

Germany. In addition, the energy sector relies strongly upon oil imports,

primarily from the Soviet Union. The country is expected to be strongly

affected by the rising trend in oil prices during the second half of 1990 and by

the Soviet decision to accept only hard currency payments for its exports as of

January 1, 1991.

The reform program in Czechoslovakia started relatively late; in 1987

the Communist government partially released market forces and decentralized

prices, stating however that it was “essential not only to preserve, but even to

enhance, the role of the centre.” The program created some incentives and

autonomy for small businesses and for private initiative in general. A more

serious change came with the June 1989 legislation abolishing traditional

annual directive plans. Stronger reform actions began in spring of 1990. A

series of laws was enacted, aimed at expanding self-financing of enterprises.

The state monopoly in foreign trade was weakened and individual exporters

could retain a certain share of their convertible export earnings. Also the

role of the State Bank has been reduced to that of a central bank, leaving

commercial activities to newly emerging independent financial institutions in

the country. Substantial tax breaks for foreign direct investment and a new

commercial code were introduced in the April 1990 legislation called “Act on

Enterprise and Foreign Property Participation.” The Act allows joint ventures

not only with state companies but also with private persons. It grants

permission to fully owned foreign companies to operate in Czechoslovakia.

Establishing a new company requires permission from the Ministry of

Finance and applications could be presented either by a local or a foreign

partner. It is no longer necessary to present a feasibility study. There is an

obligatory reserve fund and 30% of foreign currency earnings must be sold to

a Czechoslovak bank. This reserve fund is created for a purpose of introducing

limited internal convertibility of the Czechoslovak Koruna to hard currencies.

Joint ventures are permitted in all areas except national defense and their

regulations are adopted directly from the Austrian legislation. The present tax

on earning remittances is 40%, but the legislators want to cut it to 30% in the

nearest future.

The Act on Commercial Banks and Savings Banks effective January 1,

1990 creates a favorable ground for demonopolization of the financial sector

and for formation of competitive commercial banking structures. At the

present time an increasing number of international banks are opening their

branches in the country with the Japanese giants taking an unquestionable

lead.

Approaches to the program of economic reforms are much diversified.

Finance Minister Vaclav Klaus strongly favors the Polish-style “shock

therapy”—a fast move to market conditions, while many others, including the

most admired and respected President Vaclav Havel, advocate a cautious

approach. Mr. Havel recently expressed worries about “selling off the family

silver” if reform programs are too radical. Nevertheless, Mr. Klaus’s team

submitted in September 1990 a draft law on privatization and ownership

transformation. This problem is particularly difficult for this country, where

the right to use a property has been more important in legislation than true

ownership. The plan is based on a voucher program, which would give each

citizen the right to obtain a certain number of shares without payment. The

government fears that a market distribution of shares in exchange for

payment would result in snapping up the equity by foreigners, or by former

communist officials who managed to accumulate large savings over the years.

Some points of criticism can be raised to this program. Free distribution of

shares is pro- rather than anti-inflationary, since monetary assets are created

without a simultaneous reduction of excess liquidity. It is also doubtful

whether such distribution will indeed give shareholders a true sense of

ownership and, therefore, make them liable and responsible for company’s

capital. Finally, the program is not consistent with the main function of

equity emission, which is to provide a source of external capital expansion.

As a part of the financial reform the Czechoslovak government also

announced its withdrawal from Comecon’s system of fixed exchange rates, and

introduced the above described internal convertibility of the koruna in 1990.

Firms will be able to buy unlimited amounts of hard currency from the banks.

Long-term prospects for Czechoslovak reforms are relatively good.

Among positive aspects of the economy are: a good geographical position that

can play an important role in facilitating East-West trade; fairly good

infrastructure; strong international competitiveness in areas such as

printing, medicine, and engineering; and a diversified, relatively modernized

economy. A major obstacle in the transitional process is the limited skills of

upper level economic management. Many of their most qualified people,

including thousands of academic leaders, were ruthlessly transferred to

manual jobs as a result of the 1968 Soviet invasion. This painful sacrifice has

never been fully healed. There is also a growing antagonism between

Bohemia and Slovakia which may result in competitiveness and separation of

roles of regional governments in terms of their future fiscal and monetary

policies. There are claims to establish two separate central banks for both

major nations within the country.

Despite disagreements about the speed of reforms, policymakers are

consequently granting more freedom to private enterprises and to foreign

investments, dismissing state planning. The Ministry of Foreign Trade is

particularly active in advancing changes designated to facilitate joint

ventures and repatriation of profits in cooperation with several individual

governments. Most importantly, the nation is determined to support any

program leading to freedom of people, businesses, and markets.

Poland

Polish society has always taken a strong leadership in opposition to

Communism and central planning. Consequently, the Poles have moved

forward considerably in their programs of economic reform.

The present pattern of decentralization of the economic system started

essentially in 1982, when the government adopted a series of measures

loosening central controls over economic activity. At that time the number of

branch ministries was reduced from 32 to 5 and allocation of material inputs

and the foreign exchange system were much decentralized. Commercial and

noncommercial exchange rates were unified and parts of export earnings

could be retained by companies.

The next wave of reforms was enacted in 1988 and in 1989. It eliminated

all restrictions on hiring practices of enterprises. It also made far-reaching

deregulation efforts in the financial sector by establishing a two-tier banking

system and by allowing independent exchange dealership. Limits on

ownership shares of foreign investors were also phased out with expectations

of attracting foreign capital investment in the country. Finally, a year ago

the new government eliminated all administrative barriers on pricing and

distribution of food products and the authorities decided for the first time not

to prepare an annual central plan, simultaneously transforming the Planning

Commission into a new Office of Central Planning.

But the most serious and comprehensive program of economic reform

was launched on January 1, 1990 under auspices of Deputy Prime Minister

Leszek Balcerowicz. The program has been labeled an attempt to “leap to a

market economy” and is based on the following precepts:

1. Elimination of the budget deficit and easy credit policies inorder to reduce shortages and to overcome the gallopinginflation, at the 700% level in 1989.

2. Decentralization of prices and elimination of subsidies inorder to accomplish undistorted price equilibria.

3. Massive reduction of import restrictions, aimed at introducinga free trade regime and incentives for the national economy.

4. Demonopolization and privatization at the fastest possiblepace, involving most of the 7,800 enterprises in the country’sindustrial sector.

The government was largely able to accomplish these tasks using the

following means:

— a restrictive tax-based income policy, that progressively taxesexcessive nominal wage hikes over the rate of inflation;

— full unification of the exchange rate for all kinds oftransactions with the rate devalued to 9,500 zlotys per $1 (fromthe level of 6,500 at the end of 1989);

— reduction of tax breaks and subsidies to the level thatguarantees a balanced budget for fiscal 1990;

— a tight credit policy by setting the central bank’s refinancerate at the level ensuring positive real market interest ratesand by adopting measures prohibiting the National Bank ofPoland from extending any long-term credit to thegovernment;

— reduction of price controls to the present degree, where onlyabout 5% of prices are centrally fixed.

These solutions could be introduced in a prompt manner, leaving

however some major tasks for adjustment in a much longer period of time.

Among these projects are a comprehensive reform of the accounting and

taxation systems, and programs of demonopolization and privatization. Several

areas will have to be addressed in the nearest future, such as more specific

rules of profit repatriation to motivate foreign investment, a much greater

degree of liberalization of private business activity, and systems of retraining

the labor force and relocation of workers to more competitive and

comparatively advantageous allocations.

Certainly, the process of privatization could only be advanced after the

initial stage of stabilization and liberalization in order to ensure proper

structural conditions for its full implementation.

The recently announced privatization program gives a strong

responsibility for its implementation to the newly created Ministry for

Privatization and to the Council of Property Transformation advisory to the

Prime Minister Tadeusz Mazowiecki. Privatization of state enterprises will be

conducted in two stages. Initially, the firms will be transformed into a

“corporation of the Treasury Department.” Within two years the capital of this

corporation will have to be distributed to the public, either through a public

offer, or through direct negotiations with potential buyers. Employees of the

corporation will be eligible to elect one third of the Board of Directors and

after the stock emission the board will be elected by an annual shareholders

meeting. In the second stage of privatization employees will be able to

purchase up to 20% of the stock at preferential prices and anything above it at

market prices.

Initiation of a corporation will be based on a petition submitted to the

Minister for Privatization either by the company president or by the

“initiatory council.” The minister him/herself will also be able to initiate

formation of a corporation without any petition.

A large part of state property will be distributed without payment to

Polish citizens residing in Poland. The size of emission of free equity shares

will be decided by Parliament based on a request by the Prime Minister.

A questionable element in the whole program is a lack of efficiency

control and emissary function normally played by investment banks. The

process “gives away” capital to the domestic public without an access of

potential wealthy foreign investors. Thus chances for external capital

expansion for companies will be much dimmed. Also the initial privatization

of a firm will be decided upon a recommendation by consulting firms, not by

banks. Much doubtful is an effect of reduced inflation through equity

investing owing to restrictions on amounts and persons eligible to invest.

Stabilization policy outlook for next two years is mixed. Owing to drastic

measures of the reform of January 1, 1990, the rate of inflation has fallen from

a monthly level of about 78% in January to only about 3% monthly in July.

Since nominal wages lagged behind inflation the purchasing power of

society’s income has been declining, thus slowing domestic aggregate demand.

Lower real incomes will not produce demand induced inflation in the nearest

future. The unemployment rate was only about 1.5% in March 1990 but it is

expected to be higher than in most of the European nations within next two

years. Deregulation will force more efficient and productive allocations of

labor leaving many unskilled workers out of jobs. Together with the rise in

unemployment, productivity of labor has been much improved. The Polish

government recently reported lower absenteeism and fewer sick leaves

combined with a stronger motivation to work and to acquire better skills. A

large number of unemployed workers will also force the government to

promptly introduce new programs dealing with job security, unemployment

benefits, pensions, and insurance. All of them are largely unresolved today.

The strongest impediment to the reform program is the $41 billion

external debt. Excessive repayments may obstruct structural adjustments and

may jeopardize public support for the government. It is imperative to

renegotiate and to restructure this heavy indebtedness. Under the auspices of

the Brady Plan, Poland should be able to reschedule only about $10 billion it

owes to commercial banks. The remaining portion is owed to governments and

the G7 ought to act more aggressively on rescheduling this part. The most

effective reduction could be done through a comprehensive “buyback” action

in the secondary market.8 International agencies (IMF, BIS, World Bank)

have already granted some of the necessary stabilization loans for this

purpose. Considering a low value of the Polish debt in secondary markets (at

about 15 cents per each $1 of debt in April 1990) the size of the bridge loan

does not have to be insurmountable.

There also also additional positive factors in the long-term economic

outlook for Poland. The country has a geographic advantage in neighboring

unified Germany and the increasingly open Soviet Union. It is also well

endowed with natural resources, except crude oil which under the long-term

expensive trend will be burdensome to the Polish economy. In addition, the

reform program has strong public support as proven by several opinion polls

taken in spring 1990. These factors, combined with a high degree of

determination and good skills of government leaders, will encourage the

success of a prosperous future economic growth.

Hungary

Major market-based reforms were introduced in Hungary as early as in

1968 by the so-called New Economic Mechanism. There were two primary

objectives of this program: 1) a sizeable reduction of central planning

directives for enterprises; and 2) incentives for private firms and business

initiatives. Underdeveloped markets could not provide a desirable degree of

competition for decentralized firms, thus the intentions of the program could

not be fully accomplished. In addition, the inflationary shocks of the

seventies negatively affected price decentralization and profit maximization.

The government had to continue providing heavy subsidies to the economy,

despite its earlier plea to eliminate them.

The pace of economic reforms in the late eighties and in 1990 has been

relatively slower, although significant attempts at solutions have been

undertaken.

A more comprehensive program of economic stabilization was adopted

by the government in 1987. Its main tasks were:

— reduction in the budget deficit;— curtailment of excess liquidity;— reduction of the current account deficit.

8 See a detailed proposal by Sachs and Lipton, 1990, p. 65.

These contractionary macroeconomic solutions resulted in a drop in

aggregate demand and a recession in 1988 with the real GNP decline by 2%. At

the same time the rate of inflation rose to 15% in 1988 partially owing to the

introduction of the value added tax in that year. Although the current account

deficit was narrowed in the period 1986 to 1988 it later accelerated again to

about 5% of GNP in 1989. During the past two years there were large debt

service payments on the accumulated external debt of $20 billion—the highest

per capita in Eastern Europe. The pressure on balance of payments came also

from large travel spending abroad, as a result of relaxed travelling.

Recent reforms undertaken in Hungary are also ambitious.

A two-tier banking system was introduced in 1987 in order to encourage

financial intermediation. A fair number of competing banks face flexible

interest rates in all monetary markets. Credit rates for enterprises are also

market based, as well as their deposit rates. As of January 1990 most barriers to

a full integration of the banking sector were eliminated. Monetary policy has

been traditionally tight in order to ensure positive real interest rates and

highly desirable savings for the economy. The country also enacted laws

setting a framework for the first stock market in the region.

Taxation laws have been also revised. The value added tax and the

personal income tax were introduced in 1988. The most desirable

accomplishment is a reduction of the marginal tax rate to 50% in 1990, from an

excessive 60% in 1989. At the same time the corporate income tax was also

lowered from 54 to 40%.

Deregulation of commodity prices is also moving forward. The share of

consumer prices relieved from central control has gradually increased from

53% in 1988 to 77% in 1990. At the same time the structure of relative prices

has been improved through reduction in consumer and producer subsidies and

through the system of Value Added Taxation. Such system is highly desirable

from the standpoint of matching taxation rules with those of the European

Community, especially when all of the East European countries wish to

establish proper structure allowing them to join the unified Europe.

The country has also achieved much success with trade liberalization by

eliminating licensing requirements and quota restrictions for almost 65% of

comparable hard currency imports in 1990.

Much of the emphasis of the Hungarian program is put on the reform of

the process of wage determination. Pay differentials are presently more

related to job performance. Since 1989 there has been also collective

bargaining in state owned enterprises, safeguarded by taxation of excessive

wage increases.

There are several main concerns for the Hungarian government in its

future reform programs. About 90% of enterprises still remain in state hands,

which is excessive from the standpoint of improving economic efficiency.

Both inflation and unemployment are increasing at an unacceptable pace and

the level of real wages in 1990 was back to what it used to be in 1970. The

government also recently reported a 20% poverty rate measured by the

Hungarian standard. Needless to say, the most serious impediment to the faster

implementation of reforms is the excessive level of international debt.

The country may expect further assistance from the International

Monetary Fund since it has been able to satisfy several targets set for the

economy by this institution. Most importantly it was able to reduce the ratio of

budget deficit to GNP below the targeted level. It also accomplished a favorable

increase in export by 15% in 1989 compared to the previous year, which

combined with the growth of imports of only 4% reduced the size of the

current account deficit. The targeted deficit set by the IMF for 1990 is $550

million, down from $1.4 billion for 1989, and is expected to be accomplished.

The government has also issued a plan of reaching full convertibility of

the Hungarian forint. As of 1991 all foreign trade, including East European

partners, will be accounted in hard currency. Till 1994 Comecon quotas and

fixed prices will be abolished, making the forint potentially fully convertible.

Considering the fact that the country has a well educated labor force

and a large entrepreneurial and independent retail sector, its future chances

for economic prosperity are very good. Again, future success will strongly

depend upon international debt relief programs similar to those described in

case of Poland.

III. Concluding Remarks

Several comments can be derived from the analysis of ongoing

economic changes in the East European region that may be helpful for

strategic plans of multinational firms:

1. Foreign direct investment in Eastern Europe will strongly dependthe stage of economic transformation the recipient country hasreached. There are no incentives for such involvement in stage A,but it becomes increasingly feasible in stages B and C. The EastGerman rapid merge with the West and the fast progress ofstructural adjustment in Poland create favorable chances for suchplans. Hungarian reforms are also far reaching, but the favorableresults of the stabilization policy are are still remote. Majoreconomic indicators are better for Czechoslovakia, although thereform progress is relatively slower.

2. The process of economic restructuring and capital formation will belong lasting. Therefore, there will be no accumulation of incomethat could stimulate demand for imports of goods and services.Poland and Hungary face the need of debt repayments and proexportefforts. Their import demand will be particularly limited.

3. Opportunities to participate in programs of privatization areextremely limited, since its programs effectively seal capital marketsfrom foreign influences.

4. Excellent opportunities are emerging in the areas of joint venturesand infrastructural investment. Low labor costs and needs toconstruct a proper infrastructural base are evident.

5. There are exceptional needs and opportunities in the areas ofmanagement training and corporate and institutional advising.

6. Financial institutions should take advantage at the present momentof the need to establish competitive banking. Role of banks in tradefinancing (through letters of credit, bankers acceptances,forfeiting, etc.) should be significant.

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